The Monetary Economics of a Sovereign Fiat Currency System
02 December 2016 | Pago Pago, American Samoa
The key to understanding such a system is this: it replaces the budget or income constraint that businesses and households have with a inflation constraint. That is the heart of a sovereign fiat currency monetary system with flexible exchange rates like in the US has. More are starting to understand that, in such a system, revenues are not tied to expenditures, unless, politically, such a tie is forced or superimposed. A tie of expenditures to revenues is not intrinsic to the system. It is exogenous to the system and political, not economically required.
The true economic limitation is inflation which undermines the currency and the public's faith in it as a reasonable store of value. With many trillions of dollars being hoarded in cash in the US economy by the rich, the wealthy and their corporations, obviously faith in the currency and credit of the US government is not a problem, but conservatives don't or can't understand this. The minor inflation we have of 1 or 2% a year is sought by most advanced countries to counter deflation and aid growth and it is easily adjusted to and does not materially affect exchange rates.
To extend the analysis further, monetary experts now recognize the sale of bonds by the federal government to raise additional revenue
to cover the deficit is not necessary. The government could simply write checks based on its own good credit instead to do that, again subject to the limitation of inflation. Bonds are used to hoard money as a store of value and earn some interest and they are usually purchased with hoarded cash that is not circulating against new goods and services in the economy and so are not inflationary. Using checks of the government based on its full faith and credit to "cover the deficit" could be more inflationarily problematic depending on how and on what the money is spent.
Bond sales reduce reserves and the money supply which doesn't matter much if hoarded money is used to by the bonds. But expenditure of the bond revenues will increase reserves and the money supply in like amount. Alternatively, use of the credit of the government simply increases reserves and the money supply from the outset. Inflation can be quickly suppressed, if it becomes a problem, by raising taxes and selling bonds, but sitting on the proceeds of both and not spending them. That reduces reserves and the money supply.
How government credit, or the new money it creates, is spent is the key. Inflation is less a problem when such government expenditures, (whether based on credit or bond revenues) are targeted and spent to buy the services of idle people and other resources rather than those fully employed. That is so because prices are not bid up by trying to wrestle those idle people and resources away from alternative productive uses employing them. Of course this says nothing about the investment worthiness or ROI of such expenditures when public investment is the goal of either such expenditures. That is a separate topic.
For example, it is conceded by most that investment in public infrastructure in the US is desperately needed because maintenance and new investment has been neglected. Some two and a half to three and a half trillion dollars of new investment is estimated to be needed by civil engineering societies. Also, such investment is conceded to have a high ROI, properly measured.
A labor intensive infrastructure rebuilding program, spread out over a long time, and funded by government credit and/or bonds, targeting the use of idle people and other resources could be a tremendous boon to the US economy and all involved including users of that infrastructure, and be not inflationary if managed well. The only thing blocking such a program is a failure to understand all these matters on the part of too many politically involved. The additional GDP could be very substantial at little opportunity cost.
The monetary economy operates differently than many suppose and the consequences of that ignorance are extensive. We will see how the political process handles Trump's infrastructure rebuilding goal. The likelihood of successfully is low, but we can hope.